Inflationary Threat Emerging

China could soon begin exporting its price hikes. In the meantime, the rebounding dollar could hurt emerging markets, writes Eoin Treacy of Fullermoney.

Over the last few months the focus of commentary in the US and Europe has been on the threat of deflation; or probably more accurately disinflation. However this completely ignores the very real inflationary pressures mounting in higher growth regions which skirted the worst effects of the credit crisis.

Wage pressures in China have been escalating as the cost of living, not least housing, increases. Additionally, food and energy prices tend to form a much greater component of inflation measures in Asia and Latin America, so continued high grain and bean prices inevitably have a more immediate effect on CPI rates for these countries.

[China’s recent] interest rate hike raises the deposit rate to 2.25% but it remains accommodative when compared to a headline

inflation rate of 3.5%. This would suggest that monetary authorities continue to tread a careful path between fostering growth and attempting to engineer a soft landing in the housing market.

We have contended for a number of months that additional supply has been the greatest impediment to Chinese A-Share performance. This has been less of an issue since the mid-autumn festival holiday, and the Shanghai Composite has rallied impressively. Arguably, the index is a little overbought in the very short term, so some consolidation of recent gains is a possibility. However a sustained move below 2700 would be required to question potential for further upside.

Longer-term, it is easy to forget that China exerted a disinflationary influence on the global economy for a decade as it became the world's low cost manufacturing hub. With commodity prices on a long-term upward trajectory and wage pressures squeezing already tight margins, the chances that China will begin to export inflation have increased.

There has been a cacophony of protest at the speed with which the US dollar has weakened, with a number Asian and Latin American countries introducing measures to slow the ascent of their respective currencies against the greenback.

The Dollar Index has become oversold in the short-term and [last] week's rally [was] larger than any since early August, suggesting that it has found at least short-term support. The index rallied almost four points in August and a sustained move of at least that magnitude would be required to indicate that a medium-term low has been reached.

This is also the largest reaction in a number of months for the Asian Dollar Index and there is evidence in Korea and Taiwan that the weakening of the respective currencies is weighing on their stock markets.

The Latin American Dollar Index is much less overbought but has also pulled back somewhat. A sustained move above 116 is now required to reassert the medium-term uptrend. The first down week for Peru in quite some time probably marks a medium-term peak.

Given the inverse correlation between the dollar and a large number of risk assets, the likelihood that better performing stock markets and commodities are close to a medium-term peak has increased.